Economics is the study of how people, firms and governments choose how to use limited resources to satisfy unlimited wants. Everything else in the subject follows from this one problem.
1.1 The nature of the basic economic problem
Finite resources, infinite wants
- Wants are what people would like to have; they are infinite (once one want is met, another appears).
- Resources (land, labour, capital, enterprise) are finite (limited).
- The basic economic problem is that there are not enough resources to satisfy all wants.
- Scarcity is this shortage of resources relative to wants. It is the reason choices must be made.
The problem affects everyone:
| Decision-maker | Example of scarcity |
|---|---|
| Consumers | limited income, so they cannot buy everything they want |
| Workers | limited time: more work means less leisure |
| Producers/firms | limited money, machines and workers |
| Governments | limited tax revenue: more on health means less on defence |
Resource allocation: the three economic questions
Because of scarcity, every economy must answer:
- What to produce? (which goods and services, and how much of each)
- How to produce? (which methods and resources: labour-intensive or capital-intensive)
- For whom to produce? (who gets the output: how it is shared among people)
Economic goods and free goods
| Economic good | Free good | |
|---|---|---|
| Scarce? | yes: it uses resources and has a price | no: unlimited supply, no opportunity cost |
| Example | cars, food, a haircut | air, sunlight (sometimes) |
1.2 Factors of production
Factors of production are the resources used to produce goods and services.
| Factor | Meaning | Reward |
|---|---|---|
| Land | all natural resources (soil, water, minerals, forests, oil, fish) | rent |
| Labour | the physical and mental effort of workers | wages |
| Capital | man-made aids to production (machines, factories, tools, roads), not money itself | interest |
| Enterprise | organising the other factors and taking the risk of production (the entrepreneur) | profit |
Changes in quantity and quality
| Factor | What can increase quantity | What can improve quality |
|---|---|---|
| Land | discovery of new resources, land reclamation | better farming methods, fertilisers |
| Labour | population growth, immigration, more women working, longer working life | education and training, better health |
| Capital | investment in machinery | new technology |
| Enterprise | support for new businesses | experience, education |
Falls in quantity or quality (wars, ageing, depleting resources, emigration) can reduce an economy's capacity.
1.3 Opportunity cost
Examples:
- A student who spends the evening studying gives up watching a film: the film is the opportunity cost.
- A farmer with one field can grow wheat or rice: if he grows wheat, the rice he could have grown is the opportunity cost.
- A government that builds a hospital with $50m gives up a school it could have built.
How it influences decisions:
| Decision-maker | Example |
|---|---|
| Consumers | buying a phone means not buying new clothes |
| Workers | choosing a job or more education: giving up earnings now |
| Producers/firms | using a factory to make product A rather than product B |
| Governments | spending on defence rather than education |
Rational decision-makers weigh the benefit of what they choose against the opportunity cost.
1.4 Production possibility curve (PPC) diagrams
A production possibility curve (PPC) shows the maximum combinations of two goods (or types of goods) an economy can produce using all its resources fully and efficiently, in a given time.
Drawing it
- Put one good on each axis (for example capital goods on the vertical axis, consumer goods on the horizontal).
- The curve usually bows outwards from the origin (it is concave) because resources are not equally good at making both goods, so giving up more of one good to produce an extra unit of the other costs more and more.
- The curve starts at the vertical axis and ends at the horizontal axis.
Reading the points
| Point | Meaning |
|---|---|
| On the curve | resources are fully employed and used efficiently; maximum output |
| Inside (under) the curve | resources are unemployed or used inefficiently (a recession, unemployment): the economy could produce more |
| Outside (beyond) the curve | not possible with current resources and technology |
Movement along the curve
Moving from one point to another on the curve means producing more of one good and less of the other: that is opportunity cost: the units of one good given up to gain more of the other.
Shifts of the curve
An outward shift of the PPC means economic growth (the economy can produce more of both). Causes: more resources (new land, a bigger labour force, investment in capital) or better quality resources (education, technology).
An inward shift means the economy's capacity has fallen (war, natural disaster, loss of resources, a falling labour force).
A shift toward one axis only happens if technology improves in producing only one of the goods.
Practise this chapter
Every past-paper question on these topics, with the mark scheme.